Purchasing Power Parity & Fisher Effect

Question 1

Absolute purchasing power parity

Answer 1

The equilibrium exchange rate equals ratio of price levels in both nations

Question 2

Formula

Answer 2

S = P/P*
S= exchange/spot rate
P= domestic price
P*= foreign price

Question 3

The Law of One Price

Answer 3

A commodity should have the same price in both countries when expressed in the same currency.

Question 4

What is this law caused by?

Answer 4

Commodity arbitrage

Question 5

Why do we need PPP (2)

Answer 5

Exchange rate only reflects when goods are traded,
currencies are traded for other purposes e.g to buy capital assets

Different interest rates, speculation or interventions by central banks can influence the FEM.

(basically exchange rate is subject to other factors, so doesnt make it the best way to measure purchasing power)

Question 6

Purpose of PPP,

and how does it do this? (2)

Answer 6

Find differences in living standards

2. by accounting for:
   relative cost of living/inflation

Question 7

Assumption in PPP theory

Answer 7

No transportation or transaction costs , allowing prices of identification goods to be equal when expressed in the same currency, GIVEN a competitive market)

Question 8

So given this assumption:

Fluctuations in PPP are due to…

Answer 8

Relative inflation differences

Question 9

Absolute PPP theory be misleading - what does it ignore (2)

Answer 9

Ignores capital account (capital inflows=BoP surplus AS i.e foreign ownership of domestic assets, capital outflows = BoP deficit i.e investing abroad)

Ignores non traded goods - so Will not even give exchange rate that equilibrates trade in goods and services

Question 10

Relative purchasing power parity

Answer 10

Exchange rate fluctuation should be proportional to the relative change in the price levels of two nations

Question 11

Formula

Answer 11

S₁ = P₁/P₀ / P₁/P₀ x S₀

S₁ and S₀ is exchange rates in period 1 and base period

Question 12

Derivation of PPP
Price index of home country (h) and foreign (f) are equal.

Then, the home country experiences an inflation rate of 𝐼ℎ, foreign country experiences If.

What are price expressions now, for home and foreign?

Answer 12

Home price index:
Ph (1 + Ih)

Foreign:
𝑃𝑓(1 + 𝐼𝑓)

Question 13

If 𝐼ℎ > 𝐼𝑓 (home inflation>foreign) and the exchange rate doesn’t change, where is purchasing power stronger.

2. What does this mean for PPP?

Answer 13

Purchasing power is greater on foreign goods (since lower inflation)

2. PPP does not exist here. (Since PPP believes E.R adjusts to maintain parity in purchasing power, but hasn’t)

Question 14

So that scenario looked at inflation, but no exchange rate adjustment to maintain PPP.

If inflation occurs and exchange rate of the
foreign currency changes…

What does the foreign price index from the home perspective become?

Answer 14

𝑃𝑓(1 + 𝐼𝑓)(1 + 𝑒𝑓)

ef is the % change in value of foreign currency
(So same, just added the exchange rate change)

Question 15

What should ef change to?

Answer 15

Change to a value that maintains parity in the new price indexes of the 2 countries following the inflation

Question 16

How do we find 𝑒𝑓?

Answer 16

Setting formula for the new price index of the foreign
country equal to home price index.

𝑃𝑓(1 + 𝐼𝑓)(1 + 𝑒𝑓)= 𝑃ℎ(1 + 𝐼ℎ)

Then solve for ef
ef =(1+ Ih / 1+ If) - 1

(same formula as forward premium in IRP but inflation instead of interest)

Question 17

If domestic inflation (Ih) > If , what happens to ef and intuition?

If domestic inflation (Ih) < If , what happens to ef and intuition?

Answer 17

Ef>0 : foreign currency will appreciate to offset the attractive lower inflation which was causing higher demand for currency

Ef<0 : foreign currency will depreciate to offset higher inflation (since they will supply foreign currency causing depreciation)

Question 18

ef if the inflation differential is small

Answer 18

ef = Ih - If

(Don’t be confused with forward premium if INTEREST DIFFERENTIAL IS SMALL where p = home interest - foreign interest)

Question 19

Statistical test for PPP

Answer 19

Regression analysis on historical E.R & inflation differentials

T tests to coefficients: if significantly different from expectation, PPP doesn’t hold.

Question 20

What do empirical studies say about the PPP theory (2)

Answer 20

Relationship between inflation differentials and exchange rates is not perfect. (Exchange rates to not adjust perfectly to maintain parity of the purchasing powers)

However, the use of inflation differentials to forecast
long-run movements in exchange rates is supported
especially where those movements are large.

Question 21

Reasons why does PPP not occur consistently (2) (why exchange rates do not perfectly adjust to maintain parity following differences in inflation)

Answer 21

Exchange rates are also affected by other factors than just inflation

(e= f(Int, Inf,Inc,GC,EFER)

Lack of substitutes for some traded goods.

Question 22

So what does PPP work well, less well, not well for

Answer 22

Well for:
Commonly traded INDIVIDUAL commodities
Over long periods of time (flashcard 22 point 2)
Inflationary periods/monetary disturbances

Less well:
All traded goods together
Shorter periods
Periods of monetary stability

Not well:
All goods (non traded goods esp)
Short run
Periods of major structural change

Question 23

International Fisher effect (IFE) believes what (2)

Answer 23

Countries with higher inflation have higher interest rates.

Domestic real interest rates tend to equal foreign real interest rates

Question 24

Implications of IFE (2)

Answer 24

Currency with lower interest rates is expected to appreciate relative to the one with a higher rate.
(Since lower interest=lower inflation, so thus this country will sell more exports thus causing appreciation)

interest rate differential is an unbiased predictor of change in future spot rate

Question 25

What does IFE state the spot rate adjusts to?

Answer 25

Adjusts to the interest rate differential between 2 countries

(So for PPP - exchange rate adjusts for inflation to match parity of 2 price indexes S₁ = P₁/P₀/P₁/P₀ x S₀)

For IFE - exchange rate (spot rate) adjusts to interest differential (et/e₀ = 1 + rh / 1 + rf )

Question 26

Formula

What if rf is small

Answer 26

𝑒bar𝑡/𝑒₀

IFE = PPP + FE (PPP+fisher effect)

(1 + 𝑟ℎ)𝑡
/
(1 + 𝑟𝑓)𝑡

2. If rf is small
   rh - rf = e₁-e₀/e₀

Question 27

Comparison of IRP PPP and IFE theories

Answer 27

Interest rate parity - based on forward premium and interest rate differential-
should mostly hold due to threat of arbitrage (risk free) profits

PPP - based on trade and inflation differential: exchange adjusts to offset inflation differences across country. holds mainly for large/long term differences

IFE - based on investment and interest rate differential- investing in countries with higher yield (carry trade). So basically IFE means the country with lower interest rates will appreciate since lower inflation. SPOT RATE ADJUSTS TO THE INTEREST RATE DIFFERENTIAL, offsetting the gains from being lower! Offsets by SPICED, reduce exports again

Question 28

What does empirical evidence find for each parity condition

Answer 28

IRP - holds mostly

PPP and IFE likely to be violated - If held perfectly, inflation (PPP), interest rates (IFE) and exchange rates would have the same variation!

Question 29

So what is the point of parity’s if they’re often violated?

Answer 29

Provide markets best guess (still might hold in long run or for large differences)

Simple framework to determine financial linkages between countries

Show economic behaviour well for over LONG HORIZONS (if long, more likely changes are large obvs!)

Question 30

Why is country risk analysis important

Answer 30

Countrys environment may have adverse impact on forex returns

Question 31

Country risk likely normal or binary

Answer 31

Binary

E.g government either allows something or not, so 2 options

Question 32

Pros of country risk analysis (3)

Answer 32

Devise strategy appropriate

Screening device to avoid countries with excessive risk

Revise investment/financing decisions

Question 33

Political risk factors to consider in country risk analysis (6)

Answer 33

Attitude of consumers - may be very loyal to local products

Government actions - may be protectionist

Potential blockage of fund transfers

Currency inconvertibility - if so, may need to exchange earnings for goods

War

Bureaucracy

Corruption

Question 34

Financial risk factors

Answer 34

Indicators of economic growth e.g interest rates, exchange rates, inflation etc

Question 35

Macroassessment vs microassessment of country risk

Answer 35

Macro - risk assessment of a country but doesnt consider MNC

Micro - risk assessment of a country considers the MNC

Question 36

Ways of assessing country risk

Answer 36

Checklist approach

Delphi technique

Quantitative analysis e.g regression analysis to assess sensitivity of business to risk factors

Inspection visits

Question 37

Checklist approach: way of assessing country risk

Answer 37

Rating and weighting macro and micro political and financial and factors to create an overall assessment

E.g pg 56 weighting political risk e.g corruption more than financial risk e.g interest rate, inflation

Question 38

Delphi technique

Answer 38

Collect independent opinions and averaging and measuring dispersion of those opinions

Question 39

Pg 57

Question 40

How to compare risk ratings among countries

Answer 40

Foreign investment risk matrix (FIRM)

Question 41

FIRM

Answer 41

Uses intervals from poor to good, where each country is positioned on the matrix

Question 42

How can country risk be incorporated into capital budgeting analysis of a proposed project (2)

Answer 42

Adjusting discount rate - higher risk, higher discount

See how cash flows could be affected by each form of risk, to find probability distribution of net present value of the project